Europe under the spotlight
Sam Morse - Portfolio Manager
1 November 2018
After a slight recovery of markets during the second quarter of the year, the overall market tone has remained cautious and there is uncertainty about the outlook in many directions. The ongoing trade wars with no apparent end in sight, the regulatory tariffs coming into effect, the squeezing of company margins due to pressures from input prices and wage inflation all leading to a combination of negative sentiment.
Generally, there is a concern that the profit cycle may be peaking. Dispersion in valuations has grown with less favoured parts of the market such as automotives and financials looking very “cheap” if you assume that earnings hold up. Mergers & acquisitions continue to raise corporate leverage, particularly in the US.
US government bond yields have risen after the September Fed minutes. Markets have sensed that the US Fed (and maybe the European Central Bank too) will normalise policy more quickly than expected to generate some monetary firepower before the next crisis arrives. This has triggered a sharp decline in global equities coupled with a rotation away from ‘expensive’ growth towards ‘defensive’ value. Is this the beginning of the end of this stock-market cycle or just another healthy correction in a long bull market?
Earnings, although still growing year on year, are being revised down somewhat as commodities and input prices continue to rise. Margins are being squeezed, especially for companies without pricing power. Brinkmanship has been the strategy of choice in many areas of negotiation be it trade wars or Brexit; inflicting on investors the prospect of binary outcomes and the discomfort of frayed nerves. It is no surprise therefore that volatility is high.
Against this uncertain backdrop, selectivity is important and I remain focused on identifying attractively valued cash-generative companies with strong balance sheets, which have the potential to grow their dividends consistently over a three to five-year period. History shows that these types of companies perform strongly over the cycle and we expect this to continue going forward.
At the sector level, I am finding a number of these types of opportunities in areas like health care and also financials. Roche remains a key holding in the portfolio. The company is likely to benefit from its newly launched products and should be able to offset any negative impact from biosimilar entrants. It also has a strong drugs pipeline, which bodes well for the stock. I also like Sanofi, which is trading at an attractive valuation with good growth prospects in its new focus areas. It also has a new chief financial officer, which has raised the prospects for cost-cutting initiatives.
Elsewhere, I continue to like Deutsche Boerse as it has a solid balance sheet with a stable revenue stream and good growth prospects. It is also benefiting from two cyclical drivers: increased volatility and rising US interest rates. I am also positive on Intesa Sanpaolo given its attractive valuations and strong growth prospects.
Proceeding with caution in Europe
Sam Morse, Portfolio Manager, Fidelity European Values PLC
Investors in continental European markets appear increasingly cautious of late. This is not surprising given that we are, most likely, in the later stages of the economic and stock-market cycles. There is also uncertainty about the outlook in many directions: political and economic. In particular, there is a growing concern that protectionism will slow the pace of global economic growth.
Against this backdrop, it is somewhat unsurprising that equities have experienced heightened volatility over recent months. The Trust’s focus on investing in reliable dividend growers often tends to fare well in times of risk aversion.
At a sector level, technology has performed strongly - led by the strength of the sector in the US which has made European peers seem relatively inexpensive. This has benefited a number of our holdings such as Dassault Systemes, ASML, Amadeus IT Group and SAP.
A note should also be made on energy, where a strong oil price has helped major integrated companies such as Royal Dutch Shell and Total deliver on plans to improve operating and capital efficiency, enabling them to generate more cash and sustain attractive levels of dividends.
Although a high oil price is good news for these stocks, the fact that it is a key input cost for many European companies means that - with wages also rising - we may see margins come under further pressure from here.
In terms of the prospects for the broader market, an important factor to monitor will be whether the profit cycle has peaked, particularly as there is little valuation support and we are also at a time where financial conditions are tightening and the liquidity that has supported global equity markets since the crisis is being drained away.
Dispersion in valuations has grown with less favoured parts of the market such as the automobile and financial sectors appearing now to be very “cheap” if earnings hold up. So if sentiment swings again, markets could snap back with a sharp “value-led” rally.
Whatever happens in the short-term, we remain focused on attractively-valued cash-generative companies, with strong balance sheets, which have the potential to grow their dividends consistently over a three to five-year period. History shows that these types of companies tend to perform strongly over the cycle and we expect this to continue going forward.
Changes to investment objective, allocation of fees and management fees
The Board of Fidelity European Values PLC have announced a minor change to the investment objective of the Company. Following shareholder approval at the AGM the investment objective of the Company has been amended from:
“The investment objective of the Company is to achieve long term capital growth principally from the stock markets of continental Europe”
“The Company aims to achieve long term growth in both capital and income by predominantly investing in equities (and their related securities) of continental European companies”
Consistent with the changes in objective outlined above, the Board has elected to charge in future 75% of management fees and finance costs to capital, and 25% to revenue, reflecting the balance of the capital and revenue elements of total return experienced historically over the longer term. This will take effect in the 2018 financial year.
Additionally following a review of the management fees payable to Fidelity, it was agreed that the flat fee rate of 0.85 per cent will only apply to the first £400 million of funds under management and that from April 2018 a new rate of 0.75 per cent will be applied to funds in excess of £400 million.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.